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US and European High Yield: what a difference

The recent decoupling of US and European HY bonds finds its rationale in both bottom up and top down factors. Differences in market composition, in particular, played quite a role as the US speculative grade universe is more tilted to lower ratings than the European HY bonds.

A much higher exposure to the energy sector is another big part of the story while divergence in top down factors is not producing strong effects, yet. Overall, we continue to see EUR denominated HY bonds as more defensive and more supported by supportive technical than US ones, though valuations have recently moved more in favour of American HY bonds. Finally, despite recent negative impacts on energy sector, rating agencies still point to a relatively stable outlook for default rates in 2015: our box offers some details on recent trends and rating agencies’ forecasts.

Let’s start with energy…

European speculative grade bonds strongly outperformed their US counterparties in the last part of the year: a combination of factors lie behind this growing divergence in relative performance in favour of Europe. However, one factor in particular has played a crucial role and it has nothing to do with top-down forces. Rather, it appears to be the simple expression of the bottom-up composition of the two universes. The energy sector has quite a role among US speculative grade bonds, as it not only makes up around 15% of the whole market but also accounts for the same share of each single major rating category, namely BB-, B- and CCC-rated bonds. The energy sector, on the contrary, represents a marginal percentage of European issuers. The sharp fall in oil and energy prices has positive potential effects on consumers over a mid- to long-term horizon, as it frees resources that may be spent in other economic sectors, enhancing household purchasing power and therefore boosting private demand. However, in the short term it may produce quite negative impacts in exposed sectors, especially if the fall in prices occurs as suddenly and dramatically as it did in the last months of 2014. According to our calculations, the energy sector alone accounted for 50% of total negative excess returns affecting US HY vs treasuries in the period covering November to mid- December, which is much higher than its debt weight (15%).

…then move on to quality

The fact that energy makes up 15% of mid- and lower-rated US HY issuers is also quite relevant because, as we outlined in previous weekly and monthly publications, investors are no longer disregarding quality and liquidity in their search for yield. Since the October’s turmoil, BB-rated bonds have strongly outperformed B- and CCC-rated debt on both sides of the Atlantic in downturns and in recovery phases. Quality is tied to ratings, as we know, but it is also linked to another variable that is becoming more and more crucial, namely liquidity. European HY bonds, though they offer less diversifi cation than the US speculative-grade market, also have a more defensive profile. What makes them more defensive, among other factors, is the high proportion of BB-rated bonds. European BB-rated debt, in fact, make up almost two thirds or 64% of the overall market, while B-rated issuers represent 29% and CCC-bonds account for just 7%. The breakdown of US HY debt is quite different: mid- and lower-rated issuers outnumber high-rated ones, and the “weakest link” or CCC-rated debt makes up 14% of the overall market, double the proportion of corresponding European names. B-rated issuers represent another 39% of the market and only the remaining 47% is high (rated BB).

As you can see, the combination of the energy sector’s substantial weight and of the high presence of mid- and low -rated issuers mostly explains the large part of US under performance. The relative performance of each rating category in terms of OAS is shown in the reported graphs.

What about top-down factors?

The third part of the story certainly has to do with top-down forces, though these forces so far are playing a smaller role than quality and sector exposure. Default rates have fallen more in Europe than in the US and rating agencies’ forecasts for 2015 (see the box below) point to a slightly better picture for Europe in 2015 as well. It is true that growth in the US is stronger and accelerating, but at the same time monetary policy is not going to be as accommodative as in the past and especially in comparison to that of the ECB. The search for yield is still a major force in Europe, as only 15% of fixed-income instruments yield more than 2% (the percentage of instruments offering higher yields was much larger at 51% just one year ago). Given all of the above, as well the lower market weight of European HY (which accounts for just 4% of the European Fixed-Income market), technical factors look better for EUR HY as the ECB is likelier to step up its QE.

2014 saw global speculative corporate defaults falling from already low levels. According to Moody’s latest data, the trailing 12-month global speculative grade default rate finished at 2.3% last October, lower than the 2.8% rate in December 2013. Both US and Europe defaults went down but Europe contributed more to the decline in debt defaults: in fact, US HY default rates decreased from 2.2% (Dec 2013) to last 1.9% (Oct 2014), while European HY default rates fell by almost half from 4.2% to 2.3% over the same period. The current picture looks even rosier if default rates are measured not in terms of percentage of issuers but in percentage of debt. The latest available data show a rate of 1.9% for US speculative grade debt, and just 1.6% for European HY debt. The difference between the two measures implies a lower than- average default rates for big issuers with respect to medium and smaller companies.

Rating agencies remain comfortable with a benign default outlook which has been recently reaffirmed. Moody’s, for example, expects defaults to remain at low levels overall and essentially stable in one year’s time, namely at 2.4% vs. the current 2.3%. Recent trends, which are more favourable to European than to US companies, albeit to a limited extent, should also persist in 2015. US HY default rates are expected to rise slightly to 2.5% from the current 1.9%, but at the same time European speculative grade debt should benefit from a further decrease, falling from the current 2.3% to 1.9% by October 2015. In addition, S&P anticipates that the default outlook will continue to improve further for European HY companies over the next quarters, after showing improvement in line with Moody’s data.